2) Debt vs. Equity, and the Enterprise Value concept

 

There are effectively three main differences between debt and equity. Debt provides ‘fixed’ income to investors (in the form of interest payments and capital repayments), has a definite life and does not provide control/ ownership of a company (except in the event of default/bankruptcy).

Equity 

Equity provides variable income (in the form of dividends or sale of the shares), is indefinite life (it lasts as long as the company has not gone bankrupt or been recapitalised), and, generally, provides some form of control over a company.

Debt 

Debt, although frequently referred to as ‘fixed income’ actually often pays investors based on a margin over a base rate, e.g. London Inter Bank Offered Rate (“LIBOR”) + x% and thus isn’t fixed rate (as LIBOR changes, the rate paid will change).

Other important differences

There are two further points to note:
Firstly, equity does not benefit from a tax shield, where as debt interest is (for corporates at least) deductable against profits for tax calculation purposes.

Secondly debt can drive a company to default, and has greater ‘security’ over assets in the event of default than equity. If a company cannot pay the interest charge on its debt for example, the debt investors can force a default, causing the company to go into liquidation. Once this occurs, the ‘security’ the debt investors have over the assets of the company means that the debt investors will usually be able to get all of their money back before the equity investors get any (obviously if the assets of the company cannot be sold for enough to cover the money owed to the debt investors, they won’t get all of their money back, but in this event, the equity holders probably won’t get anything).

Both debt and equity can be listed on public markets (and thus bought by you or I), but generally we hear more in the news about equity markets. Equally both a great deal of debt and a great deal of equity is held privately, by wealthy individuals, hedge funds, banks, private equity funds and other organisations.

Enterprise value

Enterprise value is the theoretical ‘full’ value of a business.

There are a number of ways we attempt to measure this value: for companies that have publicly listed equity, we have a clear way of calculating the current market-implied EV. Effectively we say that the market knows the value of the company, and is subtracting the company’s debt and debt-like liabilities (debt, pensions deficit, leases etc) to arrive at the remainder, i.e. the equity value. So to calculate the implied enterprise value, we simply reverse this (assumed) process, taking the market capitalisation (or equity value) and adding back the market value of the company’s debt (or the book value if the market value is unavailable), as well as any pension deficit, lease liabilities etc to arrive at the value of the business.

If the company’s equity is not publicly traded, we must use some other methodology, such as looking at comparable companies with publicly traded equity, comparable precedent transactions (in which a comparable company was bought), or DCF based valuation. Valuation methods are discussed more fully in the Valuation section.

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